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Court of Appeal:
Non-Competition Clause Is Not Per Se Invalid If Party Only Sold Partial Business Interest
Opinion Says Contract Must Be Evaluated As to Reasonableness
By a MetNews Staff Writer
Div. Three of the Fourth District Court of Appeal has held that contractual non-competition restraints imposed following the sale of a party’s ownership in a business are not void per se if the seller retains a portion of his or her interest in the company and the agreement will instead be evaluated under a reasonableness standard.
The dispute arose after plaintiffs Robert and Stephen Samuelian sold approximately half of their 49.4 percent interest in Life Generations Healthcare LLC on Oct. 29, 2007 for about $61 million. The shares were sold back to the company, which operates skilled nursing and related healthcare facilities in California and Nevada.
Following the buyout, the Samuelians retained certain voting rights as members and the company was obligated to provide regular financial information to them.
Sec. 6.4 of the company’s operating agreement provides that “[n]o Unitholder or Manager shall…Engage in the Business within the State of California except on behalf of the Company” and defines “Business” as “(i)the ownership and/or operation of skilled nursing, assisted living, Alzheimer disease and/or physical, occupational or speech therapy facilities; (ii) the provision of nurse registry services; and (iii)…the provision of pharmacy services.”
If an owner breaches the section, the agreement allows the company to purchase all of the breaching party’s interest for fair market value. Life Generations alleges that it discovered in April 2015 that the Samuelians breached the non-competition agreement and sent them two checks totaling approximately $19.5 million to buy-out their remaining shares.
The plaintiffs did not cash the checks and initiated an arbitration action against the company and its remaining owners Thomas Olds, Lois Mastrocola, and Fred Smith III. The defendants cross-complained, alleging breach of §6.4 and seeking declaratory relief as to the buyout’s validity.
Retired Orange Superior Court Judge Stuart T. Waldrip, now an arbitrator with Judicate West, found that the non-competition provision was per se invalid under California Supreme Court precedent governing non-competition restraints following termination of employment or the sale of a company.
Waldrip ordered Life Generations to pay the Samuelians roughly $21.1 million in unpaid distributions plus interest and awarded the plaintiffs $5.7 million in reasonable attorney fees and costs.
Orange Superior Court Judge Layne H. Melzer confirmed the award and judgment was entered in August 2022.
Moore’s Opinion
Acting Presiding Justice Eileen C. Moore wrote the opinion, filed Tuesday, reversing the judgment. Moore said:
“No case has addressed this issue….A sale of a partial business interest differs drastically from the sale of an entire business interest. Following a partial sale, the seller remains an owner of the company and may still exercise some degree of control over its operations. Given this context, a noncompetition provision arising from a partial sale cannot be deemed inherently anticompetitive and invalidated per se….Rather, it must be scrutinized under the reasonableness standard to determine whether it has procompetitive benefits given the nature of the selling owner’s continuing connection to the business.”
Justices Thomas M. Goethals and Maurice Sanchez joined in the opinion.
Standards of Review
During the time of the arbitration, Business and Professions Code §16601 provided that “[e]xcept as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” Moore noted that “[u]nder section 16600, noncompetition agreements are evaluated under one of two standards: the per se standard or the reasonableness standard.”
Moore explained:
“[T]here are certain noncompetition agreements that are so antithetical to section 16600’s purpose that they are invalid per se. For example, restraints following an employee’s termination or the sale of an entire business interest (absent an applicable exception) unquestionably interfere with a person’s right to engage in an occupation or business of their choosing. Thus, they are struck down without further analysis….Yet, there are also some noncompetition agreements whose effect on competition is unclear. Such agreements must be scrutinized more closely to determine their reasonableness.”
Turning to what standard applies following the partial sale of business interests, the jurist reasoned:
“A noncompetition agreement arising from the partial sale of a business is not so obviously anticompetitive that it necessarily conflicts with section 16600’s purpose. For example, while noncompetition restraints arising from the termination of employment are invalid per se, section 16600….does not authorize an employee to transfer his loyalty to a competitor.”
She continued:
“An owner that sells their entire interest in a company is in a similar position to a terminated employee: his or her connection to the business has been severed. But similar to current employees, owners that only sell a partial ownership interest remain owners of the company and may still have a significant connection to it.”
Moore added:
“Following a partial sale, the selling owner could still be involved in operational decisions and/or receive confidential financial information about the company. Given these potential connections following a partial sale, a restriction barring the selling owner from competing with the company is not so inherently anticompetitive as to warrant application of the per se standard.”
Duty of Loyalty
The justice said that applying a per se invalidity rule could lead to a conflict with the Revised Uniform Limited Liability Company Act (“RULLCA”), which provides that selling owners may owe their company a duty of loyalty that prevents them from competing with it.
She noted that “while the…Act…does not impose fiduciary duties on members in a manager-managed company, as is the case here, it allows an operating agreement to impose such duties on members” and pointed out that “members in a member-managed company owe statutory fiduciary duties of loyalty and care to the company and other members under the RULLCA.”
Moore opined:
“We recognize that section 16600’s application is limited to ‘every contract’ that restrains competition….It does not appear to apply to the…statutory fiduciary duties imposed by the RULLCA on members unless those duties are set forth in the operating agreement or another contract. Accordingly, adoption of the per se standard to partial sales could create absurd results. Consider a scenario in which after a partial sale, the selling member signed a new operating agreement or other contract that simply reiterated its fiduciary duties under the RULLCA. Under the per se standard, this provision would seemingly be void without any analysis.”
She reasoned:
“To avoid potential conflicts between section 16600 and the RULLCA, we find the reasonableness standard applies to section 16600 when evaluating noncompetition agreements following partial sales. When applying this standard, courts can determine the reasonableness of any contractual fiduciary duties placed on a member in a manager-managed or member-managed company.”
The case is Samuelian v. Life Generations Healthcare LLC, 2024 S.O.S. 2870.
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